Monday, November 23, 2009

A Further Comment on the Term Structure of Interest Rates

In my last post, I raised some questions about Paul Krugman's view that the government should not be deterred from implementing job creation policies by the fear of raising long term interest rates:

What Krugman seems to be advocating is the following: if long term rates should start to rise, the Treasury should finance the deficit by issuing more short-term (and less long-term) debt, thereby flattening the yield curve and holding long term rates low. This would prevent capital losses for carry traders (although it would lower the continuing profitability of the carry trade if short rates rise).

In effect, Krugman is arguing that the Treasury should itself act like a carry trader: rolling over short term debt to finance a long-term structural deficit. But why is this not being done already? Take a look at the current Treasury yield curve... What is currently preventing the Treasury from borrowing at much more attractive short rates to finance the deficit? Is it is a fear of driving up short rates? And if so, won't the same concerns be in place if long term rates start to rise?

Treasury officials now face a trifecta of headaches: a mountain of new debt, a balloon of short-term borrowings that come due in the months ahead, and interest rates that are sure to climb back to normal as soon as the Federal Reserve decides that the emergency has passed.

Even as Treasury officials are racing to lock in today’s low rates by exchanging short-term borrowings for long-term bonds, the government faces a payment shock similar to those that sent legions of overstretched homeowners into default on their mortgages.

So the Treasury is currently swapping short term obligations for long term ones. Given their reasons for doing this, I don't see that the solution proposed by Krugman - that "the government issue more short-term debt" if long term rates start to rise - is going to be feasible. On the other hand, his suggestion that the Fed buy more long term bonds may still be an option.

Update: Both Dean Baker and Brad DeLong are unhappy with the Times column I linked to above, and probably for good reason. But as long as it accurately describes the current behavior of the Treasury, my argument still stands. Further increases deficit spending may be a good idea but they have to be financed in some way, and it's worth thinking about the implications of different maturity dates for new issues.